Monday, May 16, 2011

We're Number Two?

A week ago I wrote about my subjective impression that Western Europe has passed the US in terms of economic development. It turns out that that impression is generally supported by the data. The question now is what to make of it all.

The US still has more national income per person when comparisons are made using PPP exchange rates (which are meant to adjust for differences in price levels between countries); however...

A huge fraction of that higher income in the US goes purely to health care and education spending, leaving less disposable income for the US to spend on everything else;

When current exchange rates are used (which measures international purchasing power), Americans are simply poorer than Western Europeans even according to national income data; and

What's more, such data likely overstates how well off the US is, since the US's relatively unequal distribution of income means that median individuals in the US do even less well compared to their European counterparts. (It's tough to get many reliable international statistics about the median, which is why this analysis was generally forced to use means instead.)

But just looking at national income data in isolation is insufficient, so I also assembled a variety of other indicators of economic well-being. Those indicators also generally confirm the suspicion that Western Europe is now "richer" than the US. To make the comparison even more striking, the data shows that Western Europeans enjoy a standard of living surpassed by no one in the world while also having hundreds of extra leisure hours per year compared to Americans. Not a bad combination!

So it does indeed seem that Western Europe is now generally better off than the US. Note that this was not always true -- I would say that the US was equally well off 20 or even 10 years ago, though the US has always made very different choices regarding what to do with its available resources (something that should really be thought of as a separate question). But now, for the first time in my life, I am actually convinced that the US does not enjoy the highest standard of living in the world.

20th Century Convergence, 21st Century Divergence

A generation ago, the US was indisputably the richest and most advanced country in the world. And for decades after the second world war, Western Europe had been playing catch-up. "Convergence" is the term economists use to describe that process of catching up to the leading economy, and much of Europe's economic growth during the second half of the 20th century can be described by that term.

But some time around the turn of the millenium I think that convergence was complete. And since then, the continuing improvements in living standards in Europe, and the stagnation of living standards in the US, have meant that convergence has actually become divergence, with Western Europeans pulling ahead of Americans in their quality of life.

Why has this happened? The most striking systematic difference between the European economies and the US is the role played by the government. And I think that's exactly where we need to look for an explanation. Specifically, I would argue that the fundamental problem is that the US has for years been skimping on the types of crucial long-term investments that help economies develop, such education and infrastructure, while European governments have more actively sought to shape the future and prepare their countries for it. And that difference is now gradually translating into more affluence for Europeans, and stagnation for Americans.

Government Has Its Uses

The fact is that even the most orthodox, classical economic theories recognize that there are such things as public goods, as well as goods that may not be traditional public goods but still have positive externalities. We know that such goods are underprovided by the private sector. And that means that there is a role for the government to step in and provide the things that the free market doesn't provide enough of on its own. Education and infrastructure are classic examples of such goods.

Government spending can therefore very tangibly improve a country's economic well-being and growth prospects. Government regulation can correct market failures. And in situations where multiple equilibria are possible, the government can play a crucial role in helping an economy reach the "good" equilibrium. (For one particularly relevant example of the latter, it's worth re-reading Paul Krugman's old column about the amount of time that Europeans are allowed to spend with their friends and family compared to Americans.)

The importance of having a well-functioning government that isn't afraid to invest in the future has always been clearly recognized in development economics. How many underdeveloped countries can you think of that have pulled themselves out of poverty without significant government involvement and investment, after all? But I think that an important implication of this comparison between the US and Europe is that government spending -- which Europeans are simply not afraid of the way that Americans seem to be right now -- continues to be an important ingredient in the development of even the most advanced countries.

This conclusion is supported by a recent empirical study by James Alm and Janet Rogers, "Do State Fiscal Policies Affect State Economic Growth?" (pdf). Their data shows that states whose governments spend more -- particularly on education -- enjoy greater prosperity. And the same logic can be applied at the national level. European countries have been better at making productive government investments in their citizens and their cities, and they are now reaping the rewards.

In other words, while most people would agree that it is possible to have too much government spending and involvement in the economy, it must logically also be true that there is such a thing as too little government spending. And to me, it's clear that the US has crossed the line into that latter category.

Fearing the Future

Given that current state of things, it's interesting to think about what the future might hold. And that's where I get deeply, deeply discouraged.

Let's put it this way: if you were in a country that used to be the richest in the world but had recently been passed by other countries that are now more advanced or well-off, would you:

(a) decide to try to change the situation, and respond by making investments in things that will renew and sustain economic growth and development into the future, such as education and infrastructure; or would you

(b) respond by further reducing long-term investment, cutting the resources devoted to educating your population and to updating your out-moded and deteriorating infrastructure.

The US currently seems to be making choice (b).

I feel as though many Americans (or at least a very vocal and politically effective group of them) have grown afraid of the future. Afraid to recognize that change and growth can be managed, assisted, and improved upon when faced with collective confidence and creativity. Afraid to remember that the government, as a result of its unique ability to look far into the future and to consider the well-being of society as a whole, has an important role to play in making that future a better one, and improving the lives of its citizens. And so, as a result, it won't surprise me to see the US-European divergence continue for quite some time.

Contact

The Street Light is written by economist Kash Mansori, who works as an economic consultant (though views expressed here are entirely his own), writes whenever he can in his spare time, and teaches a bit here and there. You can contact him by writing to the gmail account streetlightblog. (More about Kash.)